Panera locates in urban, suburban, strip mall, and regional malls. Like Chipotle, the restaurants lean towards high quality ingredients well prepared. The menu highlights antibiotic-free chicken, whole grain bread, organic and all-natural ingredients, with zero grams of artificial trans fat per serving. There are three business segments: company owned bakery-cafes, franchises, and dough distribution to franchises and company stores.

The restaurants

The concept is part quality food at value prices and part restaurant ambiance that is warm, inviting, and embracing. While Chipotle is utilitarian, Panera wants the restaurants to be comfy and the food leans towards comfort foods—soups and warm bread. It is a very different concept.

Zagat’s 2011 consumer-generated National Restaurant Chains Survey for eating on-the-go rated them number one among chain restaurants with fewer than 5,000 locations in the Best Salad and Best Facilities categories

The bakery-cafe size is approximately 4,600 square feet and they lease all but two of the bakery-cafe locations and all of the fresh dough facilities. Average construction costs plus equipment, furniture and fixtures, and signs runs approximately $950,000 per bakery-cafe, net of landlord allowances and excluding capitalized development overhead. This compares to around $800,00 for Chipotle and $4.5 million for BJ’s Restaurants.

Franchises

Panera collects a franchise fee of $35,000 per bakery-cafe and continuing royalties of 4%-5% of net sales. Franchise royalties and fees in fiscal 2011 were $92.8 million and 5.1% of total revenues. It’s not a big percentage of the business but it’s highly profitable with low expenses for the parent and great margins. The fees and royalties are in line with other desirable fast casual restaurants. Buffalo Wild Wings gets $30,000 for the first restaurant ($25K for each subsequent location) and 5% in royalties.

Bakery-Cafe Supply Chain

Panera controls the quality of bread and other ingredients with 24 facilities that distribute to company stores and franchises daily. They supply dough for fresh bread along with tuna, cream cheese, and other consumables. Fresh dough is the key to their signature high quality, artisan bread. Distribution is through a leased fleet of 200 temperature-controlled trucks operated by their associates. They bake through the night shaping, scoring, and finishing the dough by hand ensuring fresh-baked loaves every morning and throughout the day. This segment is surprisingly profitable with 14% margins and 7.5% of total revenue.

Anatomy of a great restaurant concept?

Been searching for that for a few weeks. Preliminary work shows that it is first and foremost about the food – not a big surprise. What is intriguing is the restaurant concepts in fast casual that are doing well place their emphasis on organic or nearly organic high quality carefully prepared menus. Chipotle is the best example and Panera is similar. Chipotle is more closely aligned with quick serve and Panera closer to fast casual, but both stress the quality of the ingredients in the food.

Great restaurants have high same store sales where the base that is the biggest part of revenue keeps going forward and up. Even as new stores become part of the comp base, the year over year comparables continue to grow. Higher is better. Chipotle manages high-single digits to even mid-teens. Panera is in the mid-single digits but managing to add a lot of franchises and new stores to that base without seeing declines or negative numbers. Posting positive comps year-over-year shows the staying power of the concept even with rapid growth. Both Chipotle and Panera open in excess of 100 units in a year. Neither chain shows signs of saturation.

The successful concepts are able to add large numbers profitably and stay on the right side of cannibalization/saturation. Growing the comp base revenue is crucial, but without opening new stores, growth is capped at whatever the mature restaurants can earn. Both Chipotle and Panera can build units for under $1 million keeping capex under control and new restaurants can be built with cash flow and no debt..

What does the management of Panera regard as a metric to monitor the success of growth? It’s average weekly sales (AWS) growth.

From the Q3 conference call

A: William W. Moreton - President and co-CEO: In terms of the productivity of those [new] units may be compared to what others are talking about, I think the best benchmark or gauge of that is our average weekly sales, because again our operating P&L, once something that’s at steady state is very similar amongst our cafes.

If system-wide AWS continues to increase along with the number of new stores, it’s a good indicator that new stores are a positive and not draining sales away from the base.

The other key to great restaurant performance is to find a company that is growing transactions/traffic every quarter and every year. Panera management says that most chains cannot do much better than go from negative numbers to zero over time with long-term expectations for traffic around gains of 2%. The ability to stay in positive traffic numbers every period is difficult and important to success – higher is better.

A well-run chain will have high margins and the ability to leverage expenses across an expanding base—food distribution and chain wide purchasing boost Panera’s margins. Lower occupancy costs are also an advantage that can lead to better margins. Both Panera and Chipotle have occupancy cost of around 6%-7% of revenue. BJ’s Restaurants use 21% of revenue to pay for occupancy and have margins about half of CMG and PNRA.

The best restaurants:

• Food that creates high traffic—-at present high quality ingredients are a successful fast casual concept• Positive same store sales –higher is better• Traffic increases that are higher than price increases make stronger comps – hard to do• Stores that are relatively inexpensive to build with low pre-opening costs• Increasing average weekly sales• Ability to add a substantial number of stores without saturation• Low costs/high margins• Increasing average weekly sales

Panera meets most of these criteria (traffic could be better). For an investor one more thing is critical – catch the chain early in its growth. Panera is probably in the back half.

Q3 2012

EPS was $1.24 per share -- 28% growth over last year. Earnings have grown cumulatively by 170% since the recession of 2008. The company believes its success is based on wholesome quality food that does not disappoint returning customers and brings in new guests. The overall customer experience is important and heightened by restaurants with a welcoming warm atmosphere. The combination of inviting restaurants and consistently high quality breads, soups and salads keeps sales growing in the comp base and also supports rapid expansion of new stores and franchises.

The Q4 company owned same store sales were 6.1%. They opened 36 new stores -- 17 company and 19 franchised. Year-to-date they have opened 91 new units compared to 72 during the first three quarters of 2011. They expect to be at the high end or slightly above the 115 to 120 target range for new unit openings in 2012.

The new company stores average weekly sales were $47,438 (9 months) compared to $41,470 in 2011.

Average weekly sales increased in the third quarter year-over-year. New stores performed especially well.

Comps hover around mid-single digit. That’s fairly consistent across the past few quarters and better than the annual comps aside from a 7.5% in 2010. They never grow traffic in excess of the increase in the check, but traffic growth is positive. The company intends to look at growth in traffic in decade long trends as opposed to the shorter term moves up and down. In spite of this one shortfall, Panera manages to increase its company store revenue in high-double digits quarterly and annually.

*includes franchises, company stores and the dough/food distribution segments*gross #1 is consumables only*gross #2 is consumables and labor

Company store revenue is around 88% of revenue year to date and growth in company restaurant sales is critical. Unsurprisingly, company store revenue growth closely tracks total revenue growth.

Margins compare favorably to Chipotle who also focuses on a more organic less processed menu. Panera has better gross margins (consumables only) compared to Chipotle—70% vs 67% for Chipotle. When labor is included, Panera as a full service restaurant falls to a gross margin of 40% compared to Chipotle’s 44%.

As a full service restaurant with waitstaff, Panera outspends a restaurant like Chipotle that is largely self-serve. That makes combined gross margins lower. Panera does a good job of keeping operating and net margins high. They are lower than Chipotle, but their 14% margin food distribution segment and low occupancy costs have them beating another momentum favorite, BJ's Restaurants, by nearly double.

Tinkering with the menu is a driving force behind keeping traffic growing. The company pays a great deal of attention to putting appealing seasonal items on the menu to keep it fresh.

For instance in the third quarter:

• The Summer Celebration was key to third quarter results and directly reflects the impact of culinary skills combined with the capabilities of the supply chain organization.

• Through the supply chain system, PNRA was able to source and distribute fresh avocados into 1,600 plus bakery-cafes --real avocados and not the avocado paste that a number of restaurant companies utilize.

• The addition of the Chopped Chicken Cobb with Avocado and the return of long-term favorite Strawberry Poppyseed Chicken Salad drove salad sales up 11.6% in the third quarter.

Another tool to keep traffic high is a loyalty program. Quite few restaurant chains are now using loyalty programs to increase traffic. PNRA has 12 million members and sends emails to 8 million with a click through rate of 6%. They use it to research and analyze customer preferences and behaviors.

In spite of these strategies to increase traffic numbers are in decline. Q4 2011, Q3 and Q2 2012 all show traffic growth at less than 1% that is not impressive when looking at same store sales. Price increases have been the key to positive comps and the price increases cannot sustain them forever. In fact, a recent survey shows chains reluctant to continue price increases to support margins in 2013. Consumers want value and high prices are probably responsible for the traffic decreases across many chains in 2012. Even the mighty Chipotle saw traffic drop to around 3% growth. Restaurants will try other strategies to keep margins stable including focusing on promoting menu items that are cheaper to make and cutting portion sizes.

Panera missed traffic guidance in Q3. Management responded to an analyst’s questions about the miss by saying over five to ten years, they are in positive traffic numbers and that one quarter of missed guidance is meaningless. That may be true but three out of the last four quarters show traffic growth less than 1% along with substantial increases in price at the same time. Sometimes 2 +2 does equal 4 and they may be turning away traffic with continuing higher menu prices. They need new strategies in 2013.

Annual numbers

Even though the company takes the long-term view of comps and traffic, the past three years numbers are not impressive. Pre-2009 traffic and price increases are unavailable as the company changed its treatment of comps and while the report the total number, they fail to give the components.

Numbers prior to 2010 concerning traffic and price increases are not available. The company changed the calendar for comparable sales from 18 months to 12 months and only give complete details back to 2009.

2010 was a good year with 2012 bringing Panera back into the 7% same store sales range. Price increases contribute to most of the gains and as traffic falls below 1% increases in 2012. With price increases contributing the biggest percentage to positive same store sales, we should be looking at guest push back to the higher prices with declining comps at some point.

Growth

Revenue growth keeps Panera’s share price in premium territory. Revenue growth has exceeded the growth in comps and store additions as weekly sales increases with every new location.

Panera is raising its EPS target for 2012 to $5.86- $5.88 from $5.38 to $5.48. Bakery same store sales are expected to 4.5% to 5.5% up from previous guidance of 4.0% to 5.0% Traffic growth is estimated at growth of 0.5% to 1.0% and price increases are estimated at 4.0% to 4.5%. This is somewhat disappointing growth in traffic.

The Q4 EPS target is $1.72 to $1.74 per share

Panera also provides guidance for 2013 of $6.85 to $7 per share, for 17% to 19% growth versus the midpoint of the 2012 EPS target.

The positive effect of the 53rd week is expected to be approximately 2%.

Comparable store sales are targeted at a 4.5% to 5.5% on a 53-to-53 week scale. The 2013 commodity inflation will be in the 3% range and they will raise prices to cover the increased cost.

The new stores are targeted at 115 to 120 new units (7% increase) in 2013 with average weekly sales in the range of $40,000 to $42,000 operating margin to be flat to 0.5% higher.

Cash flow

Panera manages to have free cash flow every year since 2007. At present they have no debt and cash levels increased to $290 million in Q3. The company capex is helped by relatively low construction costs at around $750,000 (2010) per bakery-cafe, net of landlord allowances and excluding capitalized development overhead. The cost of construction is expected to increase to $950,000 for 2012 and beyond.

Like Chipotle, Panera sells at a premium and at chronically high PEs compared to market averages. Panera’s PE is 31 and Chipotle is 35. By running a DCF it is possible to see what sort of growth rate investors are pricing in to the stock. Panera does not have any debt, but the present value of the debt from operating leases was $1.5 billion and used to value the company. With an 11% discount, the market expects Panera to grow at 26% over the next 5 years with 3% terminal growth. That requires revenue to reach $11.5 billion in ten years from LTM revenue in 2012 of $2 billion. At average annual unit sales of around $3.4 per unit (assuming comp growth of 5% over 10 years), the company will need around 3400 restaurants—about double the current base. By opening 150 per year (high end of 2013 guidance), they could just about do that by the tenth year. That assumes they do not reach saturated levels, comps in mid-single digits hold, and they don’t see decreasing unit sales through overbuilding. The 26% growth rate trending down to 8% in year 9 does not appear out of reach, but we can’t know where Panera will start to experience saturation. The current price looks fully valued.

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